A simple agreement for future equity (SAFE) isn’t always so simple. Before startups and investors consider this increasingly popular security, it is important to understand how SAFEs work.
To start, a SAFE is an agreement between an investor and a business in which the business promises to give the investor a future equity stake in the company if certain triggering events take place, usually a contemplated subsequent round of financing or, less often, the sale of the company. A SAFE is usually offered in a very early round of equity funding by a startup business. They were first used in Silicon Valley as a way for venture capital investors to quickly pursue an investment opportunity in a hot startup while avoiding the lengthy and often complex negotiations required for an equity offering.
SAFEs are a relatively recently popularized investment tool. The new security is attractive to startups because it allows them (along with other untested businesses) to avoid the difficult issue of valuation when there are no revenues or a new market approach by an operating business with revenues. It resolves that valuation issue by allowing for the subsequent realistic measure of valuation by future investors in a subsequent round. SAFEs are also appealing because they reduce the risks of insolvency associated with common stock, and usually act with the rights similar to preferred stock. They are also less costly in terms of legal expenses and easier to negotiate.
While a SAFE can be attractive to both investors and startups, it is important to recognize that the security comes with unique risks. It is very different from both traditional common stock and convertible notes.
With common stock, investors receive an ownership stake in the business, which also comes with certain rights under state and federal law. Meanwhile, convertible notes are debt obligations in which the investor agrees to loan money to the business. In return, the investor receives a promise of repayment, interest on the loan for a designated time period, and an ability to convert the outstanding amount into equity of the company at some triggering event. Unlike SAFEs, convertible notes typically represent a current legal obligation by the company to the investor with a specific maturity date for repayment of the outstanding amount of the note.
SAFEs, on the other hand, may never be triggered and may never convert to equity, leaving investors with nothing in return, except the same rights as attendant to preferred stock issuances, if any, until a liquidation event. Although many SAFEs are converted into equity upon an offering of preferred stock, startups may also raise capital via additional SAFEs, convertible notes or conventional bank loans; these fundraising tools might not trigger conversion.
The provisions of a SAFE can vary significantly. Below are several key provisions that investors and startups should carefully consider:
Given that there is no “standard” SAFE, it is essential that investors understand how the terms of a particular agreement will impact your legal rights. For startups, working with experienced legal counsel can help ensure that agreements are negotiated to address your unique business interests.
If you have any questions or if you would like to discuss these issues further,
please contact Dan Brecher or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.